Fall of Major Investment Banks and Financial Institutions - Essay Example

Causes of Global Financial Crisis Introduction The global financial crisis which has its root from the United s of America late in the 20th century hit all the countries and financial markets across the world. The fall of the great 158-year-old Lehman Brothers, Merrill Lynch and American Insurance Group (AIG) is quite sensational and unbelievable. Moreover, the incidence of price cut, reduction in capital cost and other measures initiated by major automobile players such as General Motors signals the impact of crisis across industries and economies (UNCTAD, 2009). At this juncture, the present chapter attempts to analyze the impact of global financial crisis in general and automotive industry in particular. The analysis takes a global outlook to examine the various issues connected with the financial turmoil which is believed to be begun as a result of U S mortgage crisis. There are divergent opinions as to what caused this global phenomenon that resulted in the ravage and meltdown of stock markets in almost all countries. The present chapter, however, throws lights on the reasons that are generally believed to have contributed to the most distressed global crisis Causes of Global Financial Crisis 1. Subprime Lending The US originated crisis started late in the 20th century became acute in 2007 from the US subprime lending market like a distant tornado. More than two million homes financed by subprime lenders were expected to face foreclosure in the period of crisis and nearly 17% of subprime mortgages issued so far were projected to fail (Center for Responsible Lending). The roots of the current US subprime lending crisis can be traced back to the spiraling housing prices in the first half of this decade. Extremely low lending and borrowing rates increased the demand and supply of existing and new houses. Several institutions started offering subprime mortgages, to borrowers who had unfavorable credit history, at lower than normal repayment interest levels with little or no down payments. Many investment banks and hedge fund owners began to bet on this new aspect of the US economy. This had allowed investors to avail themselves of loans at low interest rates and invest them in higher yielding avenues. But soon with the US Central Bank (Federal Reserve) initiating a series of interest rate hikes leading to the increase of cost of borrowing to 5.25%, which is the maximum since the last half a decade, and a simultaneous decrease in housing prices, the subprime mortgages were reset at high rates leaving the borrowers to foreclose their accounts and miss payments (Lawrence 2000). As an outcome, financial institutions and banks with mortgage securities incurred huge losses and had to trade their assets leading to subprime lending crisis. Even though "Countrywide Financial", the biggest mortgage lender in the US, managed to withstand this crisis owing to the diversification in writing of the loans, other big players like New Century Financial, DR Horton, Weyerhaeuser and American Home Mortgage are all reeling under its impact (Kenneth 1990). 2. Low Inflation For 15 years the US economy had long and continuous economic expansion with low inflation. The US economy was following an expansionary monetary and fiscal policy. There was excess liquidity in the economy. During this period, the rate of interest was very low and there was a housing sector boom. During this good time, financial institutions, particularly investment banks showed a lot of interest in providing housing loan. They took heavy risk and made huge profits. High profits encouraged the banks to take higher risk. High leveraged transaction with life covenant became the norm. They started providing loan to prime as well as subprime borrowers though the borrowers did not have the capacity to repay the loan if the interest rate would go up. Loans were given on the assumption that housing prices always would go up and in the initial stage; borrowers were charged lower interest rate. 3. Fall of Major Investment Banks and Financial Institutions The crisis has led to the collapse of major financial institutions of the world. The losses incurred by most investment banks like Lehman Brothers, Merrill Lynch, Morgan Stanley, Barclays, Citi group, Bank of America, Goldman Sachs, JP Morgan Chase have pushed the world economy into crisis (Kenneth 1990). 4. Credit Default Swap (CDS) CDS is a credit derivative. It is insurance-like contract that promises to cover losses on certain securities in the event of a default. The CDS is typically applied to municipal bonds, corporate debt and mortgage securities that are sold by banks, hedge funds and others. The buyer of credit default insurance pays premiums over a period of time, in return for a credit protection. It is supposed to work similar to someone taking out home insurance to protect against losses from fire and theft. The CDS has become staggeringly popular, as credit risks exploded during the past seven years in the US. Banks were also happy that CDS had come to their rescue in eliminating the credit risk in their loan portfolio. Generally, banks and insurance companies are regulated by regulators of the country. But, in the case of CDS, there are no regulations. As a result, the contracts can be traded or swapped from investor to investor, without anyone overseeing the trades to ensure that buyer has the resources to cover the losses, if the security defaults. The instruments can be bought and sold from both ends-the insured and the insurer (Nelson 1990). 5. The Wall street Meltdown The Wall Street financial crisis had exposed the fragility of the system. In fact, the financial crisis is only an extension of subprime crisis that had started since 2006. The economists and others had well predicted the happening of the present crisis sufficiently early. The regulators do not seem to have given proper regulations for the fancy credit derivative namely CDS, a structured financial instrument. Further, financial institutions and other people relied on this instrument, as insurance for credit risk. All those happened vouch safe for its inherent quality, namely anybody can buy and sell this product and nobody seem to have evaluated , the ability of the ultimate borrower, on whose integrity and ability to pay or service the debt, CDS contract has been made. Naturally, all banks and financial institutions, throughout the world that have made investments in these Wall Street firms, have incurred huge losses, that had cumulative effects in stock markets, in the length and breadth of the universe (Agnor et al 1999). 6. A cut in the Fed Rate A cut in Feds funds rate has been a major factor. From October 2002 to April 2005, when the most rapid rise in home prices took place, the real Fed funds rate was negative. However, this loosening of monetary policy was due to the bursting of stock market bubble and the real estate boom was a repercussion of it. The Fed expected home prices to keep on increasing and hence focused on preventing recession. The interest rate cut cannot explain the nine year upward trend in housing market. Even when the Fed was increasing interest rates in 1999, the housing boom was accelerating. The impact of loose monetary policy was amplified by large number of adjustable rate mortgages issued after 2000, especially to subprime borrowers. Those, who were influenced by the bubble, wanted to get into real estate investment. The fact that interest rates may increase did not deter them as they expected to be compensated by increased home prices. The demand for loans with flexible standards was accommodated by the lenders because they believed in the bubble themselves. Even the rating agencies believed that there would be no bursting of the bubble. The regulators also failed to rein in aggressive lending. References Agnor, Pierre-Richard, Marcus Miller & David Vines 1999, The Asian Financial Crisis: Causes, Contagion and Consequences, illustrated, Cambridge University Press Center for Responsible Lending, A Resource for Predatory Lending Opponents, 2006, Retrieved on 07 April, 2009 from Kenneth Rogoff 1999, International Institutions for Reducing Global Financial Instability The Journal of Economic Perspectives, Vol. 13, No. 4, pp. 21-42 Lawrence H. Summers 2000, International Financial Crises: Causes, Prevention, and Cures, The American Economic Review, Vol. 90, No. 2, pp. 1-16 Nelson, Joan M. 1990, Economic crisis and policy choice: the politics of adjustment in the third world, illustrated, Princeton University Press UNCTAD, 2009, 'Assessing the impact of the current financial and economic crisis on global FDI flows', Retrieved on 07 April, 2009 from Read More